Massachusetts Life Producer Practice Exam

What percentage of a $50,000 distribution from a modified endowment contract (MEC) is taxable as ordinary income?

1. 50%

2. 75%

3. 100%

4. 25%

The correct answer is: 100%

In the context of modified endowment contracts (MECs), the full amount of any distribution, including gains, is typically taxable as ordinary income. This applies to the scenario of taking a distribution from a MEC. When a policy is classified as a MEC, it means it has failed the 7-pay test, which is designed to prevent excessive premiums from being paid into the policy in a short amount of time. Because of this classification, any distributions are subject to the tax treatment that is akin to that of ordinary income rather than capital gains treatment. Therefore, with a distribution of $50,000 from a MEC, the entire amount would be considered taxable income. This means that if a policyowner takes a distribution from a MEC, they should expect to pay income tax on the full amount received, which in this case is 100% taxable as ordinary income. The rationale for the fully taxable nature stems from the accumulated earnings in a MEC, which bypass the tax-deferred growth that is typically afforded to life insurance policies until a distribution is made. Understanding these tax implications is essential for anyone involved in life insurance sales or financial planning, as they help inform clients appropriately about the potential tax liabilities associated with their contractual choices.